A Process for Early Payoff of Student Loans
There are many articles and resources available for student loan holders who are looking for options to reduce their monthly payments and get loan forgiveness. Focusing on a different set of borrowers, this article is targeted at student loan holders (either private or federal student loans) who aren’t eligible for forgiveness and want to assess the early payoff of their student loans. For these borrowers, they may be motivated to:
- Reduce the total amount of interest paid over the life of their student loans, and/or
- Eliminate their student loan debt to free up cash flow to put towards other financial goals, such as buying a house or long-term savings.
The process defined below is very similar to the process for assessing early repayment of other types of loans, such as mortgages.
Note that the terms “loan prepayment” and “early payment” used throughout this article mean payments made in excess of the normal monthly loan payment. Such excess payments are made in an effort to pay off the loan early.
- Assess Your Current Financial Situation
I recommend this initial step before making any significant financial decisions. The best way to do this is to create (or update) your Balance Sheet (Net Worth Statement) and Income Statements.
- Refresh Your Loan Details
About 8% of student loan debt in the U.S. is held by private lenders, and the rest is managed under the category of Federal Student Loans. The suspension of federal loan payments since early 2020 might have resulted in changes to your Federal Student Loan servicer or your personal information.
-
- For private student loans, get the latest status of your loans from the lender.
- Federal Loans – go to studentaid.gov.
As part of this loan data gathering process, review your options for making early payments, particularly to ensure how to make early payments that are applied 100% to paying down the principal owed.
You should also consider setting up automatic monthly payments, as many loan providers offer an interest rate reduction (typically in the 0.25% range) to customers on an automated payment plan.
- Create a Budget
Once the Balance Sheet and Income Statement are in place, and you’ve confirmed your Student Loan details, create a Budget based on your short-term (three-to-six month) income and expense rates, which includes the monthly student loan payments you owe per the existing loan terms. For Federal Student Loan borrowers who have been reallocating their student loan repayment budget to other uses during the pandemic-driven Federal Loan payment suspension, you need to budget for the restart of payments on these loans on October 1, 2023.
- Assess Various Budget Options
If your initial budget, with your standard monthly student loan expense included, has a positive cash flow (i.e. your income exceeds your expenses), I encourage you to take the following steps before making any student loan prepayments:
-
- Pay off high-interest rate credit card debt. Typically, credit card debt will have the highest interest rate of any personal debt, and you will make a more-significant impact in reducing your interest-related costs by eliminating any excess credit card debt as quickly as possible.
- Create an emergency fund to cover three to six months of living expenses.
- Contribute to your employer retirement account, ideally at a level to get the maximum employer match amount. The employer match is additional income that should be acquired if possible. If you don’t have an employer-sponsored retirement plan, budget at least 5% of your gross income towards an individual retirement account.
- Use a Tool to Calculate the Impact of Early Student Loan Repayments
I suggest using one of the many online loan prepayment calculators, which makes the process of assessing various prepayment rates (and their effects) fairly simple. I have used the Student Loan Repayment Calculator at https://www.calculator.net/student-loan-calculator.html. With such a tool, you enter your existing loan details including loan balance, interest rate and monthly payment, then enter additional prepayment amounts to see the impact on loan term reduction and the reduction in interest paid.
- Making Student Loan Prepayments
You have completed the previous steps and have positive monthly cash flow that allows student loan pre-payments. Now it's time to make a student loan payoff plan.
- You will want to decide how much your early payment will be, which is dictated by the excess positive cash flow defined in your budget. Note that you can adjust the amount and frequency of these optional early payments if you need to.
- Presuming similar interest rates, you should pay off private student loans before federal student loans. Federal loans are more likely to offer forbearance options, may have greater repayment flexibility, and have forgiveness potential.
- If you have multiple federal student loans, consider consolidating them into a single loan to simplify loan management, noting that there may be fees to do this. Skip this option if the fees are excessive or if loan consolidation results in an increase in the interest rate paid across your entire loan balance.
- Once any private student loans are paid off, I recommend you then apply loan pre-payments to the remaining loan with the highest interest rate. This allows you to pay off the most expensive debt first, resulting in the maximum reduction in interest paid.
- Ensure that your early payments are being applied to loan principal reduction. Your instructions when making an early payment should specify that the prepayment is an extra payment toward the principal balance of the loan and should not be treated as an early payment of the next installment.
There are a lot of factors to consider when assessing early loan payoffs. If you need help assessing your financial situation, calculating the impact of student loan pre-payments, and factoring such payments into your budget, you may find it helpful to talk to a financial professional.
*This content was developed from sources believed to be providing accurate information. The information provided is not intended as tax or legal advice, and readers are encouraged to seek advice from their own tax or legal counsel. Neither the information presented, nor any opinion expressed, constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Eustace Advisors to provide information on a topic that may be of interest. Copyright 2023 Eustace Advisors.
Resources